Bumps on the ethanol highway

Questions about the corn ethanol industry's profitability are beginning to slip into news coverage that, on the whole, continues to be overwhelmingly positive.

Indeed, to an outsider, the industry's recent rapid expansion — and the seemingly unbridled enthusiasm surrounding it — might bring visions of a '90s-style dot.com bubble about to burst. But unlike the dot.com era, the corn ethanol industry's success is tied to one fundamental — strong demand for liquid fuels.

“In the U.S., we have had an insatiable demand for energy that isn't likely to change,” notes Chad Hart, an Iowa State University (ISU) economist with the Center for Agricultural and Rural Development. “Because of this, ethanol has strong potential for growth.”

To lend perspective to questions about the industry's future, we asked Hart, coauthor of a recent ISU study on the impact of the ethanol industry on agricultural commodities, to highlight challenges that could face the industry in the next few years. (The study, “Emerging Biofuels: Outlook of Effects on the U.S. Grain, Oilseed, and Livestock Markets,” is available at www.card.iastate.edu/publications/synopsis.aspx?id=1050[3].)

Hart identifies five factors, in order of their potential impact, that could affect the profitability of the corn ethanol industry in the next few years. The factors highest on the list, such as dramatically lower oil prices and reduced government support for ethanol, are wild cards. They're unlikely, but if they were to occur, they could have a major effect. Other factors, which are lower on the list, are likely to occur, but are unlikely to have as much impact.

Factor 1

OIL PRICES

According to the ISU study, the oil futures market suggests that prices are likely to remain in the $65/barrel range for the foreseeable future. However, Hart says that oil prices tend to be volatile and that prices in the $20 to $40 range are fairly recent. So although dramatically lower oil prices aren't likely, they are possible.

“If we were to return to $30/barrel oil, that would tend to put the brakes on the U.S. ethanol industry,” Hart says. A November 2006 ISU study calculated that, at $40/barrel oil, ethanol refiners could afford to pay $2.67/bu. for corn. “Today's corn prices couldn't be supported if crude oil was below $40/barrel,” he adds.

Factor 2

GOVERNMENT SUPPORT

Given recent energy bill deliberations, support for ethanol probably won't fall by the wayside. “The government is moving toward more support,” Hart says. But this wild card could have a big impact if it were to occur.

Factor 3

OTHER BIOFUELS

Political support for ethanol from cellulose continues to be strong, but this technology isn't competitive with corn-based ethanol at this point. (See “Suitable cellulose,” page 28.) If and when ethanol from cellulose becomes viable, the impact on corn-based ethanol could be substantial.

“Producing cellulosic ethanol is technically feasible, but it is not economically competitive at this point,” Hart says. “Right now it costs at least $1/gal. more to produce ethanol from cellulose than from corn.” Researchers around the world are working to improve the process, but getting breakthroughs from the lab to the pump could take years.

Biobutanol (butyl alcohol produced from biomass) is another technology to watch, though it also faces development challenges to improve its efficiency. If these challenges were solved, this fuel would have the advantage of being able to be shipped through gasoline pipelines, since it isn't as corrosive as ethanol.

Factor 4

THE E10 BOTTLENECK

Industry projections suggest that annual U.S. ethanol production capacity could reach 12.6 billion gallons in two to three years, more than enough to supply ethanol to blend with gasoline in states requiring 10% blends. The oversupply, often called the E10 bottleneck, will be a drag on ethanol prices — and dampen corn markets as well.

“We will be sitting with ethanol supplies that exceed demand, which will lower ethanol prices and cut back the profit margins of ethanol plants,” Hart says. “This could lead to a pullback and consolidation of the industry.”

Although other factors also are involved, the stock price of large ethanol refiners already might be reflecting this eventuality. In mid-July, the stock price of VeraSun Energy Corporation, the nation's second-largest ethanol producer (behind Archer Daniels Midland) was about $14, about half of its November 2006 value. The price of U.S. Bioenergy Corporation stock, number three in the market, was hovering at about $11 per share, down about a third from its all-time high of $17 in late 2006.

What will happen to corn prices under the E10 bottleneck scenario is open to debate, but the recent ISU study suggests that $3/bu. is a reasonable price to use for long-term planning.

Corn prices would be under pressure as ethanol prices trended lower, towards a price reflecting ethanol's relative energy value, which is about two-thirds that of gasoline.

“Once we hit that bottleneck, how quickly another outlet for ethanol develops will determine what happens to prices,” Hart says.

The ethanol fuel market for E85 vehicles is unlikely to have a big impact in the short term, because few stations carry E85 fuels and the total fleet of E85 vehicles is relatively small — only 2 to 3% of the U.S. vehicle fleet.

Raising ethanol fuel blend mandates to 15 or 20% would soak up excess ethanol supplies, but such a state-by-state change could take years to go into effect, Hart says. Currently, only one state, Minnesota, has mandated a 20% blend, but with a provision that it goes into effect only if there is proof that vehicle operation isn't negatively affected by the higher ratio.

Factor 5

POTENTIAL BACKLASH

“There is potential for a backlash against ethanol if the public perceives it as a major driver in food price increases,” Hart says.

The ISU report projects relatively modest food price increases in the 1 to 3% range, with meat facing the largest increases, as a result of increased ethanol production from corn. A widespread 1988-style drought could exacerbate public concerns about the food-fuel trade-off, but Hart doubts that the food price debate will rise to a level that will affect the outlook for the corn ethanol industry.

Similarly, he doubts that environmental concerns will have a big impact on policy or price, although there could be a public relations fallout. “I don't think the debate has reached a crescendo yet,” Hart says. “We could see the debate broaden as the impact of adding more corn acres is realized. We are running a big test case now as we increase corn production.”